Trends in future commerce: Regulating the Canadian blockchain space

The invention of blockchain technology has created an industry market capitalization of $400-700 billion, and every country – including Canada – wants a piece of the action. Now, the challenge is figuring out how to regulate these financial technology (fintech) companies and their methods of raising capital through initial coin offerings (ICOs). In an industry where overregulation could suffocate innovation, striking the right balance in Canada could be the difference between being a country that attracts foreign blockchain startups and investors, or one that loses out to countries with fewer rules.

How does Canada fit into the global blockchain market?

From the formation of the Blockchain Association of Canada, to the large number companies (including IBM, Bell, TD, CIBC, and Microsoft) that have joined Canada’s Blockchain Research Institute (BRI), to the creation of the Ethereum blockchain (an open software platform based on blockchain technology used to create decentralized applications, or dapps) by Canadian Vitalik Buterin in 2015, Canada is a leader in blockchain innovation.

There has been a significant uptick in Canadian blockchain growth in the recent years. Etherparty, a Vancouver-based blockchain startup, is focused on simplifying smart contracts (automated, self-executing contracts created in computer code) so that the technology is accessible to everyone, regardless of their knowledge of code. Etherparty is backed by another Vancouver company, Vanbex, which has serviced some of the biggest names in blockchain technology. In Eastern Canada, Stack, based in Toronto, is partnering with Mastercard to create a cryptocurrency payments app and card that will allow consumers to pay for everyday goods at point-of-sale with their cryptocurrency.

How can we foster growth for Canada’s blockchain companies?

Companies using blockchain technology have developed a crowdfunding method called an initial coin offering (ICO), which operates similarly to a stock offering without the related costs and legal framework. That is, until the proper regulation is developed. The key to growing Canada’s blockchain industry will be ensuring that over-regulation doesn’t stifle innovation the way it has in countries like China, which temporarily banned cryptocurrency exchanges and ICOs in the latter half of 2017.

China’s regulation has spurred many companies that either provide cryptocurrency exchange services or want to issue their first ICO to move their headquarters to Singapore, where both the central bank and the Monetary Authority of Singapore have said they will not regulate cryptocurrencies. Since Canada will need to compete on a global scale, it's important that Canadian regulators strike a balance between regulation and innovation.

What is an Initial Coin Offering (ICO)?

As mentioned, an ICO helps companies raise funds (in this case, cryptocurrencies like bitcoin or ether) to finance their projects in a similar manner to an initial public offering (IPO). Offering companies typically publish a whitepaper outlining the project’s plan and details, but instead of offering shares in the company, ICOs offer investors specifically created tokens that can have different uses on the company’s platform; for example, some companies allow their tokens to be used to buy goods or services on the company’s specific blockchain platform or app. Unlike an IPO, investing in an ICO won’t result in ownership of the company. However, like with securities, investors buy with the notion that the token will increase in value. This would generally occur when the token/technology achieves higher adoption levels than at its outset.

Why can’t ICOs be regulated the same way as other securities?

This new way to raise capital has piqued the interest of securities regulators. The U.S. Securities Exchange Commission (SEC) and the Canadian Securities Administrators (CSA) have both put out notices that ICOs might have to start being treated as securities offerings, and therefore face the same regulatory environment. Fintech companies argue that certain tokens purchased through ICOs are not akin to an ownership stake in the company, but are used to purchase services that the company offers. Global regulators rebut that the active trading that happens after the ICO pushes these tokens closer to being shares of a company.

Because many countries don’t know how to regulate ICOs yet, offering companies are left trying to navigate murky regulatory compliance, often opting out of including residents of certain countries to avoid regulatory complications and leaving many people who want to participate in ICOs on the sidelines. For instance, Kik, the Canadian based popular messaging platform, completed a $100 million ICO in September 2017 to fund their blockchain venture but ultimately didn’t allow Canadians to invest due to regulation fears. However, since then, the Ontario Securities Commission (OSC) has expressed that it is looking to foster growth in the fintech and blockchain space, and they even greenlit Canada’s first ever regulated ICO in October 2017.

To move out of this grey area, fintech companies need regulation from authorities like the Financial Transactions and Reports Analysis Centre of Canada (FinTrac) and the OSC, as well as the SEC in the United States, to ensure that citizens within their borders are transacting fairly and that Know Your Client (KYC) and Anti-Money Laundering (AML) protocol are followed.

Until there is clear regulation that works for both fintech companies and securities regulators, offering companies like Kik will simply restrict residents of the US or Canada from participating in their particular ICO to avoid scrutiny by the OSC, SEC, and other Canadian and American regulators. Therefore, both sides will need to find common ground to move forward.

Why should countries regulate blockchain companies and ICOs?

Securities regulators everywhere are tasked with striking the proper balance between fostering innovation and protecting the consumer from unpredictable fallout from new business models and financial products, such as initial coin offerings. The disruptive power of blockchain has posed new questions to supervisory bodies that control how financial markets can operate. This is a particularly challenging task due to the high risks attached to the financial industry. And since the technology itself is so new (Bitcoin, the world’s first cryptocurrency was only created in 2009, and the Ethereum blockchain was created in 2015), there is limited available guidance regarding the regulation of fintech startups.

In an innovative space known for libertarian thinking, it is natural for blockchain startups to push back against regulation. And, with a technology that promotes a trustless protocol, rendering intermediaries and authorities redundant, why should innovative companies continue to comply with and support regulators? At the end of the day, regulation comes down to a matter of protection:

Protect the public: Everyone recognizes the public good in shielding the customer from unscrupulous practices;

Protect the company: In order for a company to navigate its future, it needs to know what its regulatory parameters are. Rules, when implemented properly, will help provide structure for how to navigate this regulation; and

Protect the system: Once the financial system is built on blockchain infrastructure, safeguards will need to be put in place to ensure that the system does not fail.

Is there any regulation for blockchain companies in Canada yet?

The CSA, like most governments trying to attract and retain fintech investment, has adopted the sandbox approach. In February 2017, the CSA launched its Regulatory Sandbox Initiative – where highly innovative companies (including fintech companies) can apply to be able to interact with the general public and test their products and services throughout the Canadian market while remaining generally exempt from securities law and regulations. This initiative allows authorities to gain a better understanding of how technological innovations are impacting capital markets, and assists regulators in evaluating the industry to modernize the securities regulatory framework for fintech firms.

Moving forward, those who are involved in the Canadian blockchain space are hoping for well-researched guidance from regulatory bodies such as the CRA, the OSC, BC Securities Commission (BCSC), and the CSA.

What will happen if Canada over regulates blockchain companies?

As the pace of innovation in the financial sector accelerates, a restrictive regulatory environment can be an impediment to innovative business models. Savvy startups shop these regulatory environments as part of competitive due diligence. With low-touch regulatory regions like Singapore attracting innovative companies, investment in technology will flow to the region with the most attractive sandbox. With a $500-700 billion industry at stake, the government who produces the best sandbox wins.

If we end up at a point where it becomes more of a burden than a benefit to do business here, Canadian innovators will end up leaving to places that provide a better regulatory framework, resulting in lost growth opportunities and Canada will be left behind during what could be a defining evolution of how business is done.

Regan McGrath, CPA, CA, is the founding partner and CEO of Metrics Chartered Professional Accounting, and Kyle Mackenzie, CPA, is a partner, CTO, and blockchain specialist at Metrics Chartered Professional Accounting.